A view from the Top : CBN jumps into inter-bank market

CBN experimenting with new models in currency markets

While the response to the recent tightening measures by the CBN has been a moderation US$ demand at recent WDAS auctions and an appreciation in the official USD/NGN exchange rate to N149.94/US, the Naira has continued to show signs of weakness in the interbank and parallel markets.  On the interbank market in particular, the Naira has declined 4.40% to N158.98/US since the end of Q2’11, as compared to the 2.50% appreciation recorded on the WDAS over the same period. As at yesterday, the divergence between the WDAS and interbank market rates stood at N10.98 (close to the 2011 high of N12.11).  In response to this situation the Central Bank of Nigeria (CBN), yesterday released guidelines on its planned intervention in the interbank market. In a statement explaining the decision, the apex bank noted that it plans to intervene in the interbank market in two ways:

Method A: Intervention through the purchase and sale of US Dollar directly from/to Authorized Dealers.

In this method of intervention the CBN will buy or sell US dollars to Authorized Dealers in the interbank market through the submission of bids and offer rates for specified amounts of USD. This process, while similar to the WDAS, will not replace the bi-weekly auction but instead will enhance the CBN’s capacity to maintain liquidity through increased frequency of sales to Authorized Dealers. Furthermore, the guidelines for Method A noted that the spread between the bid and offer rates presented to the CBN in such bids may not exceed 20pips (20 kobo) and will be settled into the Authorized Dealers’ Trading Nostro Settlement Accounts  as opposed to their FEM Nostro Settlement Accounts, which are used to settle WDAS transitions.

Method B: Intervention through direct market participation

This method entails the CBN, active participation in the interbank market like any other registered bank.  The guidelines stipulated that with effect from Monday October 24^th 2011, the CBN will begin contacting Authorized Dealers and providing bid/offer quotes for the standard trade amount of US$250,000 with the standard spread of 5pips (5 kobo). However, the guidelines further state that Authorized Dealers will be allow the increase their required bid/offer spreads to 20pips (20 kobo) in cases where the CBN opts to demand amount greater than US$250,000.

A departure

In what appears to be a an attempt to enhancement market liquidity, the intervention guidelines allow the resale of US dollars purchased from the CBN on the interbank market to other Authorized Dealers on the interbank market, even as a separate circular (also released on October, 20^th 2011) revised the Foreign Exchange Net Open Position for Authorized Dealers to 3% from 1%, which was pronounce at the emergency MPC meeting last week.  However the guidelines, stipulates that Authorized Dealers would not be allowed to move funds from their FEM Nostro Settlement Accounts to Trading Nostro Settlement Accounts to settle interbank transactions. Furthermore, while Non-settlement of transactions with the CBN would not necessarily result in cancellation of the intervention to Authorized Dealers; defaults on either US Dollar or Naira settlements, within T+2 of the transaction with the CBN would attract suspension from WDAS spot and forward markets.

What is the CBN trying to achieve?

My guess is that this move may be designed to help the CBN gain better visibility into trends in the interbank markets and allow it take greater control of events in that market. However, the CBN is probably also trying to alter the economics behind demand and supply of foreign exchange. By participating in the inter-bank, it is able to adjust its interventions in a more timely fashion, a facility that may, help it fight adverse trends. In a sense, the new system moves us closer to a market structure I have long advocated, where CBN participates, like other dealers, in a common market,  responding to market vagaries as best suits its policy goals.

The impact of the new system could be far reaching and, while it does not entirely remove the ills of the old system, I am sure that it is a step in the right direction. I expect to see a little more volatility in exchange rates and assume that with the adoption of the new regime the CBN could become somewhat more flexible in the WDAS as well. In fact, I suspect that if it is able to achieve its aims of better managing the market the CBN may use this as a stepping stone towards a more “liberalized” regime.

Naira Blues

The naira falls to new low

At last Wednesday’s WDAS auction the Naira declined 0.97% to N156.91/USD, its lowest point since the inception of the current currency regime, as the CBN sold US$400 million, as against US$736.94 million demanded. On the interbank market, the Naira closed at N 164.30/USD, after falling to an all-time low of N167.40/USD during trading, as the parallel market remained at N166.5/USD. Yesterday’s Naira move on the WDAS marked its 55th decline in 74 auctions held this year and leaves the Naira N2.40 above the upper limit of the CBN’s +,-3% of N150 range. Though this spike in demand pressure at the WDAS was not unexpected given the recent breach of the CBN’s peg, the extent of Naira devaluation in recent weeks has increased concerns about the CBN’s currency policy and its ability maintain stability. In response the CBN took severe policy action at yesterday’s MPC meeting where the committee decided to:

·         Raise the Monetary Policy Rate (MPR) by 275bps to 12.0%.

·         Maintain the symmetric corridor of +/-200bps around the MPR.

·         Increase the Cash Reserve Ratio (CRR) by 400bp to 8.0%.

·         Suspension of the averaging method for reckoning of CRR in favour of daily position limits.

·         Reduce the Net Open Position (NOP) from 5.0% to 1.0% of shareholders funds.

MPC decisions should provide ST support

I am of the view that two of the key decisions made at yesterday’s MPC are likely to have a short term impact on the direction on the Naira. On the one hand, the MPC’s decision to hike its MPR by 275bp will improved the Naira’s attractiveness on an interest parity basis. On the other, the MPC’s decision to slash bank’s Net Open Position (NOP) from 5% to 1% of shareholder funds with effect from October 14^th should provide some support for the Naira as it effectively increases the CBN’s US$ position at the expense of the banks. Furthermore, from the next action the MPC has decided to restrict banks access to the Standing Lending Faculty (SLF) to fund WDAS purchases. With these policies, the CBN will able to curtail banks ability of bid for USD while, forcing them to unwind current dollar positions. The joint effect should moderate demand and strengthen the CBN’s dollar position in coming auctions.

Interest party in focus

With interest parity in particular, my review of global currency markets reveals the most major African frontier market currencies have experienced significant declines relative to the US dollar in recent week. In particular the South African Rand (ZAR), Kenyan Shilling (KES) and Ghana Cedi (GHC) have declined 17.52%, 7.51% and 19.70% respectively since the beginning of July. Furthermore, my research shows that, while no statistically significant at the 70% level; the extent off currency declines for each country is uncorrelated to the respective Monetary Policy Rates in 2011. For instance, while South Africa maintained a MPR of 5.50%, the ZAR decline almost as much as the KES, which has a corresponding MPR of 11.0%.

While the above fact does not invalidate the relevance of interest rate parity, it lends some credence to view that interest rates may not be the principal driver of capital flows across Sub-Saharan Africa. For Nigeria in particular, this view is reinforced by the fact that, in spite of consecutive interest rate hikes in March, May, July and September, the value of direct remittances (a proxy for non-trade related WDAS demand composed largely of financial instrument transfers by non-Nigerian individuals and corporations to their home countries) has continued to raise, an indication of continued capital outflows.  

Impact to be short-term at best

We are of the view that as was the case with prior policy thus far in 2011, the impact the MPC’s policies will be short lived. This is because, while the policies will do much to address possible demand side inefficiencies and speculative attacks on the Naira at the WDAS, it does nothing to correct the fundamental trend in demand, which is largely driven by increasing imports. Of note, import related USD demand at the WDAS, has constituted over 65% of average WDAS demand since H1’09, also average demand at the WDAS has risen 24.42% YoY to US$397.88 million per auction in 2011. In comparison our estimates show that t the CBN’s policy of reducing bank’s NOP will result in a maximum is an inflow of US$520 million[1], barely enough to meet demand at one WDAS auction at current levels.

On the interest party side, while the MPR hike is positive for the Naira, I am mindful that other frontier markets are likely to enter similar tightening cycles in the near future. As result, it is unlikely that interest parity will be the only determinant of capital flows going forward as my research as shown. This fact may have the effect of dampening the support for the naira in the short term.

Reserves never Lie

Try as it may, to regulate the Nigerian Foreign Exchange market, the CBN’s ability to defend the Naira is ultimately limited by the level of foreign reserves, which remains stunted at US$31.30 billion in spite of higher crude oil prices and crude production thus far in 2011. With recent reports indicating  that  Nigeria has struggles to sell Crude oil Cargoes in October and November, it is likely the further accrual to reserves may be delayed even as we enter the peak of the September – November window. As such, while I expect the naira to rebound slightly in the coming days, my expectations for the Naira remain tilted towards the view that it will remain under pressure in the short run as the continued depletion of reserves weighs on the CBN’s ability to maintain stability. 

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[1] Based on shareholders fund provided by CBN , March 31^st 2011